2.
a large array of ﬁnancial products remains undeveloped and often very
limited in less developed economies due in part to the inability of these
countries to develop an institutional framework suitable to the develop-
ment of new ﬁnancial products and to handle their underlying contracts.
Financial development is not a natural upshot of the interplay of free
market forces. Rather, a reverberation of political and property rights of
institutions ensuring sound macroeconomic policies and strong legal
protection for stakeholders in ﬁnancing contracts. Understanding the
likely causes of the lack of ﬁnance and low level of ﬁnancial develop-
ment across countries and regions requires the analysis of views outside
of the realm of traditional ﬁnancial intermediation theories. This compels
us to ask the question of why ﬁnancial markets are still undeveloped in
many countries while so many (developing) countries appear to have
been relatively quite successful in implementing institutions more con-
ducive to ﬁnancial development by lowering country systemic risks so
that ﬁrms might have easier access to external ﬁnance. More importantly,
why have so many countries managed to increase intermediation despite
institutional weaknesses.
The law and ﬁnance literature posits that unlike French civil law
countries, British common law countries have been very successful in
implementing institutions conducive to property rights protection and
thereby ﬁnancial development. Despite this, many civil law countries
have circumvented their legal heritage to devise a framework that al-
lows ﬁrms to have relatively better access to external ﬁnance while
many common law countries have failed to capitalize on their legal her-
itage to set in motion institutions conducive to ﬁnancial development
and growth. In fact, as illustrated in Fig. 1, the theory is at odds with
recent data on the spread of ﬁnancial services around the world. New
data, over the period of 2004–2011, extracted from the International
Monetary Fund's (IMF) database show that countries with French civil
law heritage have increased the scope of ﬁnancial services and have
done so substantially more than their British common law counterparts.
In a broader sense, to comprehend why many developing countries
have been lagging behind in terms of advances in intermediations for
so long, one needs to ﬁrst grasp the conditions under which intermedi-
ations have thrived. This requires us to bring into perspective the role of
the formal and informal institutions in devising ﬁnancial contracts.
There is much less research into what types of institutions – property
rights or contracting rights – are more conducive to ﬁnancial develop-
ment and what types of new institutions are most needed to stem disin-
termediation. This delineation may shed some light on how to leapfrog
some institutional weaknesses to framing systems that allow private
parties to contract with each other and achieve greater redeployment
of assets through enhanced intermediation. The law and ﬁnance litera-
ture, while highlighting the importance of institutions for ﬁnancial
development, is rather thin on the types of institutions that lead to better
ﬁnancial outcomes. It concentrates on the importance of formal
institutions, bureaucratic capacity, government stability, law and order,
and private sector organization. However, explanations of why and how
private parties leap over their weak judicial system to enforce ﬁnancial
contracts are vague and under-developed.
Are property rights institutions more relevant to ﬁnancial develop-
ment than contracting rights institutions? Are formal institutions more
conducive to ﬁnancial contracting than informal institutions? Aggarwal
and Goodell (2009) surmise that since all optimal contracts are incom-
plete, and the efﬁcacy and efﬁciency of overcoming contracting costs
depend not only on the legal environment, but also on ethical and other
informal conventions, industrial structure, and social and cultural values.
Understanding the effects of property and contracting rights, formal and
informal institutions on ﬁnancial contracting, enforcement mechanisms
may be of great importance for multinational and portfolio investors as
well as policymakers.
This paper presents a framework for understanding the kinds of
institutions necessary for successful ﬁnancial development. It brings in
insights from law and ﬁnance as well as other bodies of literature on in-
stitutions, ﬁnancial development, private contracting, and government-
ﬁrms and private citizens interactions. It expressly concentrates on
property and contracting rights, formal and informal institutions, and
how do they affect ﬁnancial outcomes. It underscores the institutional,
information and larger banking reforms that are needed for sustained
growth in intermediation. By focusing on informal institutions and
contracting rights, it adds to the ongoing debate on ﬁnancial develop-
ment by exploring other facets of private monitoring and access to ﬁ-
nance. Overall, it feeds the debate regarding the relations between
political institutions and ﬁnance, and the linkages between habits, cus-
toms, traditions and credit ﬂows to the private sector. As a consequence,
it has implications for ﬁnance, economics, politics and sociology.
The remainder of the paper is organized as follows. The next section
presents a review of the relations between various forms of institutions
and ﬁnancial development. Section 3 summarizes our argument and
presents some perspectives along with some policy issues related to
institutional choices and their implications to ﬁnancial development.
Section 4 concludes with a set of reforms needed to increase ﬁnancial
intermediation and access to external ﬁnance.
2. Financial development and legal institutions
This study brings together different strands of related literature on
institutions and ﬁnancial development. The ﬁrst thread, the law and ﬁ-
nance literature, is regrouped under a series of studies by La Porta et al.
(1997, 1998). This branch of literature relates country legal heritage and
institutional infrastructure to investor protection and minority rights.
The second thread, the institutions literature, which is substantiated by
Acemoglu, Johnson, and Robinson (2001, 2005), relates more to property
rights protection. The third thread of literature, dominated by a series of
research by Levine (1997), Rajan and Zingales (1998), and Levine
(1999), offers a broad view of the ﬁnancial development literature.
This latter thread of literature analyzes the differences in countries'
level of ﬁnancial development as a reﬂection of their formal legal
system. The current study transposes this strand of literature by relating
the theories of institutions or property rights of institutions and con-
tracting rights of institutions to the level of ﬁnancial development, and
the ease with which ﬁrms within a certain institutional framework have
access to external ﬁnance even when they have to use informal channels
to enforce ﬁnancing contracts.
2.1. Institutional differences and external ﬁnance
Financial development hinges around the issue of how well a
country's institutional arrangement allows for optimal allocation and
redeployment of investible resources. The effective implementation of
010203040
English Socialist French German Scandinavian
Commercial bank branches per 100000 adults across legal systems
Commercialbanksper100000adults
Fig. 1. Commercial bank branches per 100,000 adults across legal systems.
26 I. Marcelin, I. Mathur / International Review of Financial Analysis 31 (2014) 25–33

3.
institutions, along with rules enforcement mechanisms, allows not only
the creation of ﬁnancing contracts but also their validity in courts. The
possibility of creating viable ﬁnancing contracts should, in effect, facilitate
innovation and increased intermediation. The efﬁcacy and independence
of the judiciary, culture, and customs are likely to play an important role
in facilitating access to external funds. Recent discussions on institutions
and ﬁnance suggest judicial inefﬁciency and a weak judicial enforcement
of debt contracts lead to higher cost of ﬁnancial intermediation
for households and ﬁrms (Leaven & Majnoni, 2005).
When faced with a predatory state, private citizens have no recourse
against extractive policies. In some countries, however, citizens may
petition the courts and challenge the legality of the government’s actions
and prevail. These countries are endowed with the types of institutions
deemed more conducive to private property rights and ﬁnancing con-
tracts. In other countries, where the courts are uniformly weak, although
citizens' private property rights may not be properly safeguarded through
formal institutions, private citizens might create some forms of en-
forcement mechanisms for private ﬁnancial contracts. This requires
the implementation of several tools anchored in the country's ethical
and informal conventions with deep roots in social and cultural
values.
Due to variations in informal or social conventions across countries,
the mechanics of ﬁnancial development might have shifted towards
greater reliance on private monitoring, enforcements and market disci-
plines. This is not only meant to prevent the whole ﬁnancial system
from systemic disruption or dysfunction; but equally, to ﬁll the gap left
behind by disintermediation. Thus, institutional choices and their imple-
mentation cannot be separated from the ability of the courts to enforce
them.
Even when formal institutions are inefﬁcient, the ﬂow of private
credit, although limited, may be facilitated by private arrangements.
However, such a modus operandi should work against ﬁnancial
deepening by inhibiting the ﬁnancing of economically valuable projects.
Acemoglu and Johnson (2005) and Fernandes and Kraay (2007) differ-
entiate between property rights of institutions, protecting the rights
of citizens against predatory states and contracting institutions, set of
rules, as well as practices and customs governing private contracts be-
tween private citizens. Using data from the Enterprise Surveys database
by the World Bank, Fig. 2 shows that not only is there a higher propor-
tion of ﬁrms with bank loans in French civil law countries, but the
proportion of loans requiring collateral is lower in these countries than
in British common law countries. This suggests that private citizens do
get around their legal and institutional weaknesses to devising tools
allowing the creation of ﬁnancial contracts thereby resulting in an
increase in intermediation.
2.2. Institutions, costs of funds, and ﬁnancial intermediation
Other key considerations to ﬁnancial development are net interest
margins and interest rates spread. An essential function of institutions
is to curb systemic risk, and as a result, ﬁnancing costs — the spread or
risk premiums. This holds both for removing barriers to ﬁnance and
lifting the level of ﬁnancial development and economic activities in a
country. Flows of credit and investments in economically viable projects
can be snagged by banks' high net interest margins, and borrowers' ad-
justed risk premiums. Also, uncertainties over payments and settlement
activities may stiﬂe the amount of credit that a ﬁnancial institution may
want to extend to ﬁrms when repayment costs are uniformly high.
When trade-offs between returns on loans and risk associated to them
are unjustiﬁably high, this results simply in disintermediation.
The association between ﬁnancing costs and institutions' quality has
been explicitly analyzed through the prism of the relation between the
courts and ﬁnance. Many studies ﬁnd that ﬁnancing costs are signiﬁcantly
higher in countries with ineffective judicial systems (Demirgüç-Kunt &
Huizinga, 1999; Demirguc-Kunt & Maksimovic, 2002; Francesca & Giorgio
Di, 2004; Leaven & Majnoni, 2005). Particularly, Demirgüç-Kunt and
Huizinga (1999) ﬁnd that banks in developing countries are more proﬁt-
able than their developed countries counterparts. Moreover, indicators
of better contract enforcement, efﬁciency in the legal system, and the
lack of corruption are associated with lower interest margins and lower
proﬁtability.
Magda, Tullio, and Marco (2005) stress that there is no conclusive
relationship between institutions and bank spread; however, they con-
cede that the relationship depends on banking competition and the type
of judicial reform undertaken. In effect, judicial efﬁciency may be the
best proxy for institutions, but the quality of the judiciary, in many
developing countries, depends not only on the ability of the courts to
enforce contracts, but in the complexity of the ﬁnancial products and
contracts that the judiciary is handling. Whether the quality of the institu-
tions determines the level of intermediation and innovation or whether
it is the other way around, remains a matter of empirical interest.
Another research suggests margin to be a function of a country's
laws and institutions (Demirgüç-Kunt, Leaven, & Levine, 2004; Leaven
& Majnoni, 2005). Demirgüç-Kunt et al. (2004) argue that among the
obstacles to ﬁnance is interest margin. The authors conclude that net
interest margins are narrower in countries with better institutions.
When a banking sector enjoys high net interest margins, this is an indi-
cation of an inadequate availability of credit, and market distortions in
terms of lack of competition and market power of banks. High interest
margins and spreads represent the state of ﬁnancial intermediation
in a country, i.e., the extent of distortions in ﬁnancial markets and the
level of difﬁculty involved in monitoring ﬁnancing contracts and collec-
ting claims.
Weak institutional settings are consistent with an inefﬁcient and de-
pendent judiciary, which in turn, entails a number of consequences for
ﬁnancial development. The most economically impactful consequence
may be an increase in ﬁnancial disintermediation, backwardness, or
sustained under-development; and, as a result, new ﬁnancial markets
and products fail to emerge. This means that ﬁnance seekers should
ﬁnd it extremely difﬁcult to issue claims to savers in the form of
bonds, commercial papers, equity, or other vehicles such as derivatives
because, in part, it is nearly impossible to create those instruments
without inshore intermediation or underwriting services. With the
increasing diversity of the ﬁnancial system, the role of banks and the na-
ture of banking have also become more varied and complex. The greater
overall complexity of the ﬁnancial system may increase informational
contagion across institutions and markets (see Crockett & Cohen, 2001).
It is noteworthy to highlight that in a disintermediated ﬁnancial en-
vironment, ﬁnancial intermediaries and end-users will not be familiar
with many types of ﬁnancial products along with the risk they entail;
and as a corollary, systemic risks, inherent to ﬁnancing activities, should
be much severe with subpar institutions, thereby leading to higher
050100150
English Socialist French
Pct. of firms with bank loan/line of credit Proportion of loans requiring collateral
Value of collateral needed for a loan (%of the loan amount) Pct. of firms not needing a loan
Barriers to finance across legal systems
Fig. 2. Barriers to ﬁnance across legal systems.
27I. Marcelin, I. Mathur / International Review of Financial Analysis 31 (2014) 25–33

4.
ﬁnancing costs. What is less clear, however, is the extent to which insti-
tutions have held back ﬁnancing to the private sector while tacitly en-
couraging lending to the public sector, oftentimes, at exorbitant rates.
Moreover, as a ﬁnancial innovation, hindered by the quality of the judi-
cial system, warrants the following question: What would be the effects
of any disruption in the ﬁnancial infrastructure on broad impacts of the
ﬂow and availability of credit?
Institutions reﬂect risk, values, and national consensus. Some values,
in effect, may bend toward a culture of corruption and extraction and,
when channeled through the established institutions, they are likely
to contribute to lower growth in the broader economy. There are, un-
doubtedly, larger sets of risks borne by developing countries' lenders.
In order to mitigate their exposures, these lenders would likely elect
to adjust their loan sales by setting high interest rates, reducing matu-
rities as well their amounts. Since risk is inherent to lending, can loans
really be priced to adequately reﬂect real lender risk exposures where
extractions and extortions are commonplace? Thus, improving the efﬁ-
ciency of the credit markets along with the ﬁnancial infrastructure, and
improving the quality of the country's institutions via the legal machin-
ery is crucial to ﬁnance, investment and growth. However, despite the
institutional deﬁciency prevailing in French civil law countries, new
data shows little support for the well-established theory that ﬁrms in
common law countries should face less obstacles to external ﬁnance.
Demirgüç-Kunt and Huizinga (1999) use bank data from 80 coun-
tries and show that differences in interest margin and bank proﬁtability
reﬂect various determinants including bank characteristics, macroeco-
nomic conditions, taxes, regulations, ﬁnancial structure, legal and insti-
tutional indicators. Their indicators of better contract enforcement,
efﬁciency of the legal system and lack of corruption are associated
with lower realized interest margins and lower proﬁtability. Their
results suggest that legal and institutional differences matter. The re-
sults also imply that the superior proﬁtability of developing countries'
banks is consistent with higher risk environments but starkly contrasts
with the poorer institutional framework in developing countries.
La Porta et al. (1998) argue that the legal system in a country is the
primary factor of the effectiveness of its ﬁnancial system given the im-
portance of ﬁrms and investors to effectively transact with each other
and through the ﬁnancial system. Modigliani and Perotti (2000) em-
phasize that in the absence of a strong legal system that can protect
the rights of external investors, ﬁnancial transactions are intermediated
through institutions or concentrated among agents who have sufﬁcient
bargaining power to enforce their rights privately (Demirguc-Kunt &
Maksimovic, 2002). A direct application of the Coase Theorem yields
that, absent signiﬁcant transaction costs, capital suppliers and users
should negotiate, agree, and privately contract on the efﬁcient level of
investor protection, when that level is not provided by the law
(Bergman & Nicolaievsky, 2002).
In many institutional contexts, the body of written laws, the formal
institutions, may be supplanted by the informal institutions' customs
and traditions. Institutions can be theoretically and conceptually strong
but weak in practice. In reality, the institutions that matter go beyond
the written laws. If the laws are enforced, then this will reverberate in
the quality of these institutions to eventually impact systemic risk,
investment patterns, and lending/borrowing relationships. Where
poor institutions are an impediment to ﬁnance, the spread should not
only be set high, but also banks should be more eager to channel
funds to least productive and risk-free borrowers such as the state. In
fact, Malouche (2008) reports that in Sierra Leone commercial banks
have traditionally often preferred to take a conservative attitude to the
granting of credit and investing in government Treasury Bills/Bonds.
As of July 2013, a one year Treasury note in Ghana yields 22%, while
the 6-month T-bill caries 23.0314%.
The main vehicle through which banks beneﬁt from loan sales is
through the spread. The lower ﬁnancing costs imply fewer obstacles
to external ﬁnance and thereby greater ﬁnancial development or en-
hanced intermediation. Financing costs have numerous implications
for ﬁrms and other fund borrowers such as: (1) preventing projects
with positive NPVs from ﬁnancing by making bank credit difﬁcult to ob-
tain, and (2) worsening ﬁnancial position of already high risk borrowers
with low net worth while increasing the default rate on bank loans. In
fact, when weak banks deal with a riskier clientele they are expected
to charge higher premiums as their expectation of bankruptcy for
their borrowers is high.
It has become clear that banks in ineffective institutional settings are
expected to have high discount rates and a short investment horizon,
especially when they are weak and faced with capital constraints.
Demirgüç-Kunt and Huizinga (1999) highlight the large beneﬁts
of judicial efﬁciency on the reduction of banks' net interest income,
independently from any notion of market power. This may hide differ-
ent levels of judicial effectiveness across developed and developing
countries where typically banking markets are more concentrated and
judges could more likely be captive of the economic power (Leaven &
Majnoni, 2005).
2.3. Institutions as a determinant of ﬁnancial development
By facilitating access to external ﬁnance, some forms of institutions
may support lending to the real economic sector and thereby contribute
to productivity improvements; whereas, others may contribute to
diverting scarce resources to non-productive uses, thus creating dis-
incentives to investors in growth enhancing activities. Both the law and
ﬁnance and the institutions' literature provide ample theoretical justiﬁ-
cation of a lasting trait of the colonial institutions on today's institution-
al infrastructure.
Veblen (1899) observes that the situation today shapes the institu-
tions of tomorrow through a selective and coercive process by acting
upon men's habitual view of things, and so altering or fortifying a point
of view or a mental attitude handed down from the past (in Chavance,
2009). More recently, Acemoglu et al. (2001) assert that the colonial insti-
tutions propagated during the colonization era persisted well beyond
independence. The law and ﬁnance theory holds that the propagation
of legal traditions had enduring inﬂuences on national approaches to
private property rights and ﬁnancial development.
Levine (2005) argues that the Napoleonic institutions built upon the
French civil law system are more rigid and formalistic than those built
upon the British common law system. This rigidity has varied conse-
quences on these countries' banking ﬁnancial systems. According to
Merryman (1996), the exportation of the French civil law to its colonies
had more pernicious effects on property rights and private contracting
than the Code's effects on France and other European countries where
it has been adopted. In addition, while colonies imported the inﬂexibil-
ity associated with antagonism toward jurisprudence and reliance on
judicial formalism, most did not learn how the French circumvented
the adverse attributes of the Code (in Levine, 2005). As a result, the in-
imical effect of the formalism of the French civil law institutions leads to
a ﬁnancial sector that is lagging behind in terms of innovation, and
adoption of new ﬁnancial products, and the prevalence of high costs
of capital.
Beck and Levine (2002) ﬁnd that differences in legal traditions in the
priority they give to individual investors' rights vis-à-vis those of the
state have consequences for the development of property rights and
ﬁnancial markets. The authors argue that legal systems that (a) reject
jurisprudence (the law created by judges in the process of solving
disputes); and (b) rely instead on changes in statutory law will tend
to evolve more inefﬁciently with the negative implications for ﬁnance.
Djankov, La Porta, Lopez-De-Silanes, and Shleifer (2003) look at the in-
cidences of legal formalism by measuring the number of formal legal
procedures necessary to resolve a simple case of collecting an unpaid
check or evicting a non-paying tenant. They ﬁnd that countries with
greater legal formalism have higher costs of enforcing simple contracts,
longer delays in courts, and lower perceived fairness and efﬁciency of
the judiciary system.
28 I. Marcelin, I. Mathur / International Review of Financial Analysis 31 (2014) 25–33

5.
Data from Doing Business and Enterprise Surveys show the little
support that ﬁrms housed in common law countries enjoy to better ac-
cess to some kind of ﬁnancing. Fig. 4 exhibits that the proportion of
investments ﬁnanced by retained earnings are of equal magnitude at
common law and civil law ﬁrms. Supplier credit is an excellent source
of ﬁnance for many ﬁrms both for ﬁnancing new projects and working
capital needs. Indeed, the proportion of investments ﬁnanced by suppli-
er credit is higher in French civil law but the proportion of working cap-
ital ﬁnanced through the same tool is higher for common law ﬁrms.
Overall, Fig. 3 offers a mixed panorama on the ease of access to ﬁnance
across legal systems.
Nonetheless, when the quality of a country's institutions is poor, the
interactions between banks and these institutions may justify a mean-
ingful reform to slow down ﬁnancial disintermediation. It seems that
ﬁnancial reforms are more consequential to ﬁnancial intermediation
than legal heritage. Such reforms may be fruitless where the capability
and the incentives to carry them out are either absent or trumped by
special interests and powerful elites, especially where the status quo
protects entrenched beneﬁts for potentates and bankers as suggested
in Demirgüç-Kunt and Huizinga (2001), and Flamini, McDonald, and
Schumacher (2009).
2.4. Property rights, contracting rights and ﬁnancial development
Acemoglu and Johnson (2005) and Fernandes and Kraay (2007)
argue that the interaction between the state and ﬁrms and/or private
individuals is a vertical relationship while the interactions between
private companies is a horizontal relationship. Fernandes and Kraay
(2007) explain that a country might have weak property rights institu-
tions with strong contracting rights institutions because the latter
reﬂect the extent to which the courts allow private parties to contract
to each other. Along the same lines, Acemoglu and Johnson (2005) high-
light the notion that private citizens/investors develop informal sets of in-
stitutions to circumvent the court when dealing with each other while
they have no recourse when faced with a predatory state. This implies
that private property rights institutions may be more relevant to ﬁnancial
development than the contracting rights institutions.
Illustrating two approaches of the law and ﬁnance theory, Beck,
Demirgüç-Kunt, and Levine (2003) postulate that in countries where
legal systems enforce private property rights, support private contractu-
al arrangements, and protect the legal rights of investors, savers are
more willing to ﬁnance ﬁrms and ﬁnancial markets thrive. They put for-
ward an approach whereby political systems work through differences
in legal traditions, especially in terms of the priority they attach to a
private property vis-à-vis the rights of the state and the protection of
private contractor rights. They further expound an adaptability system
referring to the degree of formalism in the legal system that, if overdone,
may impair the legal system's capability to minimize the gap between
the contracting needs of the economy and the normative status quo.
The governments in French civil law countries tend to enjoy
greater latitude in their abilities to funnel resources toward politically
advantageous ends even if this abrogates private property rights and
pre-existing contracts. They have difﬁculty in committing to refraining
from interfering in private contractual agreements (Levine, 2005). A
legal system’s weakness in enforcing contracts certainly provides
fodders for corruption and expropriation, which may run from
state-to-ﬁrms or ﬁrms-to-ﬁrms. Ahlin and Pang (2008) show that
low corruption and ﬁnancial development facilitate the undertaking
of productive projects, and that ﬁnancial underdevelopment makes
corruption more onerous and thus raises the gains from reducing it.
Using data from the Doing Business database of the World Bank,
Fig. 4 depicts the association between the courts and access to external
ﬁnance. It shows that low court effectiveness is associated with lower
access to ﬁnance. In line with the extant literature on institutions and
the law and ﬁnance, the picture shows that French civil law countries
are more corrupt than common law countries, but the high level of cor-
ruption has not erected steeper barriers to external ﬁnance. In fact, ﬁrms
in common law countries appear to be facing more obstacles to external
ﬁnance than their French civil law counterparts. This suggests that
informal institutions such as social norms and habits may supply some
monitoring and enforcement mechanisms playing thus an equally im-
portant role in facilitating private contractors to do business with each
other.
Demirguc-Kunt and Maksimovic (2002) posit that the absolute
quality of the banks and securities markets in a country depends on
the legal system's ability to enforce contracts. They further argue that
the legal system across countries may have a comparative advantage
in supporting a quality banking system or a quality of securities. Levine
(2005) suggests that the security of property rights is an outcome of
policy choices and social institutions. The protection of property rights
requires a balance between (1) an active government that enforces prop-
erty rights, facilitates private contracting and applies the law fairly to all;
and (2) a government sufﬁciently constrained that it cannot engage in
coercion and expropriation.
2.5. Institutional view of ﬁnancial development
North (1994) deﬁnes institutions as humanely devised constraints
structuring human interactions, and distinguishes formal from informal
institutions. Chavance (2009) explains that it is possible to change
020406080
English Socialist French
Proportion of investments financed internally Proportion of investments financed by supplier credit
Proportion of working capital financed by banks Proportion of working capital financed by supplier credit
Access to finance across legal systems
Fig. 3. Access to ﬁnance across legal systems.
05101520
English Socialist French
Obstacles to external finance and Corruption,
Courts effectiveness across Legal systems
Obstacles to finance Corruption Courts
Fig. 4. Obstacles to external ﬁnance and corruption, courts effectiveness across legal
systems.
29I. Marcelin, I. Mathur / International Review of Financial Analysis 31 (2014) 25–33

6.
formal institutions overnight, but the modiﬁcation of informal institu-
tions takes place over a very long period of time, which is why revolu-
tionary transformations are never as far-reaching as their advocates
would like, and the transfer or imitation of formal institutions between
countries does not achieve the desired results. North (1994) further ar-
gues that countries that adopt the rules of other countries will have very
different performances because of differences in informal norms and
enforcement mechanisms. Simply transferring the formal political and
economic rules of successful Western market economies to Third World
economies is not a sufﬁcient condition for performance (in Chavance,
2009).
In reality, governments can make new laws and create new in-
stitutions aimed at supporting ﬁnancial development in ways that
would reduce risk for ﬁnancial intermediaries to emerge and decrease
transaction costs for ﬁnance seekers. Nevertheless, these laws would
be meaningless if their enforcement is not supported by informal insti-
tutions such as customs, traditions and social norms, allowing formal
institutions to serve as effective and fair umpires between stakeholders.
Formal institutions do not operate in a vacuum, i.e., all types of institu-
tions are interdependent. Aoki (2000) argues that institutions may be
codiﬁed and represented in an explicit approach, but the codiﬁed insti-
tutions will have institutional characteristics only if agents collectively
believe in them. For instance, statutory laws and regulations are not
institutions if they are not followed (see Chavance, 2009).
2.6. Informational reform and ﬁnancial development
Private and/or public credit registries are another type of institutions
affecting ﬁnancial intermediation and ﬁnancing outcomes. Miller (2000)
explains that credit information registries refer to a database of informa-
tion on borrowers in a ﬁnancial system. The information in these regis-
tries is available for individual consumers and/or ﬁrms and includes a
borrower's past payment history, such as late payments, defaults, debt
outstanding, and regularity of payments. Such registries, however, may
serve a limited purpose if implemented in countries where the institu-
tions are uniformly ineffective and of poor quality.
Despite its relative technological advantages, it appears that the ﬁ-
nancial sector in emerging economies is unable to deepen ﬁnancing
and efﬁciently channel ﬁnancing primarily as a result of informational
challenges, lack of bank information sharing, and increased bank secre-
cy laws. Crockett and Cohen (2001) argue that with the increasing
diversity of the ﬁnancial system, the role of banks and the nature of
banking have also become more varied and complex. Moreover, the
greater complexity of the ﬁnancial system may increase informational
contagion across institutions and markets. With the lack of viable infor-
mation gathering and processing mechanisms, transaction and informa-
tion costs as well as information asymmetries are expected to be high.
Innovation should allow a country to leapfrog its outdated institutional,
ﬁnancial, and economic infrastructures reducing the information gap
between lenders and borrowers.
Without the necessary informational and institutional reforms, and
in spite of its capability to perform ex-post monitoring and verify the
stated and seeming ﬁnancial strength of borrowers to minimize the
risk of default, it might be difﬁcult for a bank to efﬁciently apply its
expertise to scrutinize start-ups, small ﬁrms, and ﬁrst time borrowers
when credit information is deﬁcient or simply absent. In this instance,
ex-ante monitoring plays a vital role in ﬁnancing new projects, and po-
tentially lessening the risk of adverse selection, reducing the spread, and
creating wealth through the ﬁnancing of positive NPV projects. This
suggests that credit registries should play a key role in increasing inter-
mediation along with ﬁnancial innovation.
In many countries, credit information agencies are mostly nonexis-
tent, and if they do exist, they are mostly symbolic. Miller (2000) sur-
veys Latin American, Eastern European and African banks on their use
of credit reporting to grant credit to borrowers. A surprising 28% of
banks in the survey were not familiar with such a product known as
credit reporting. Only 40% of the surveyed banks indicated that they
use scores reported by those registries. Among those familiar with cred-
it reporting systems, 76% indicated that they would deny credit alto-
gether if a negative information was reported about a client's credit
history. Conversely, Brown and Zehnder (2007) analyze the impact of
the introduction of such credit registries on loan repayments, and ﬁnd
that the introduction of a registry signiﬁcantly raises both repayment
and the credit volume extended by lenders.
Love and Mylenko (2003), and Djankov, McLiesh, and Shleifer
(2007) concur that bank credit to the private sector increases where in-
formation sharing institutions are more developed. Pagano and Jappelli
(1993), and Kallberg and Udell (2003) argue that information sharing
reduces selection costs for lenders by allowing them to predict loan de-
faults. Padilla and Marco (2000) underscore that creditors often share
information about their customers' credit records to help them to spot
bad risks. They further maintain that if creditors are known to inform
one another of defaults, borrowers must consider that a default on
one lender would disrupt their credit rating with all other lenders.
Their argument, however, might apply to a limited fraction of the
world where records about ﬁrms and individual customers are kept
and efﬁciently used in credit allocation. This disciplinary function through
information sharing is at best minimal in many developing countries
where information about ﬁrms is sensitive and does not ﬂow from one
lender to another through institutional channels to force borrowers to
keep their record intact.
Many countries have implemented credit information bureaus to
keep track of consumers' and ﬁrms' credit histories. Although the bank-
ing literature has shown the importance of information in banking
(Diamond, 1984), the effects of such new institutions on net interest
margin, interest rates spread and loan quality are less understood due
to another signiﬁcant research gap. Ideally, effective credit information
institutions should produce low costs for information, and give rise to
productive activities making lending/borrowing relationships healthier.
North (1994) argues that if institutional framework rewards productive
activities, then organizations will likely engage in productive activities.
For example, in banking, ﬁnancing these productive activities will make
lending/borrowing relationships healthier since ﬁrms will generate
adequate cash ﬂow to grow and service their debt.
2.7. Power of creditor and ﬁnancial development
A new thread of literature within the family of the ﬁnancial develop-
ment research deals with the power of creditors. It speciﬁcally pertains
to whether secure creditors are paid ﬁrst from the proceeds resulting
from liquidating bankrupt ﬁrms. It holds that when secure lenders have
priority claims in bankruptcy proceedings, it is easier for them to commit
important ﬁnancial resources to ﬁrms' long-term ﬁnancial needs.
Extending the earlier work of La Porta et al. (1997, 1998), Djankov
et al. (2007) literally analyze the impacts of secure creditors' ability to
recover collateral when debtors ﬁle for bankruptcy or enter reorganiza-
tion without a stay order or an asset freeze imposed by the court, on
ﬁnancial development. They ﬁnd that both creditor protection through
the legal system and information sharing institutions are associated
with higher ratios of private credit to GDP, but that the former is
relatively more important in richer countries. They also ﬁnd that legal
reforms contribute to improvements in creditor rights, and that infor-
mation sharing precedes faster credit growth. They ﬁnally report that
creditor rights are extremely stable over time, contrary to the conver-
gence hypothesis. This latter ﬁnding is consistent with the view that
institutions are stable and hardly change over time.
Safavian and Sharma (2007) study two aspects of the law and
ﬁnance theory: the laws on creditor rights and the quality of contract
enforcement by courts. The authors ﬁnd that the effectiveness of credi-
tor rights is strongly linked to the efﬁciency of contract enforcement. In
addition, ﬁrms have more access to bank credit in countries with better
creditor rights, but the association is weak in countries with inefﬁcient
30 I. Marcelin, I. Mathur / International Review of Financial Analysis 31 (2014) 25–33

8.
This would allow central bankers to strategically reorient credit
towards vital sectors within an economy. This would signiﬁcantly reduce
information asymmetric problems since management would have to
disclose a slew of information, which would have been kept secret other-
wise. The role played by the banking sector in monitoring and sanctioning
ﬁrms' management would be enhanced by the existence of such a struc-
ture. This would lead to lower costs of credit thereby increasing the level
of ﬁnancial development. A study by Boot and Thakor (2000) highlights
the fact that information asymmetry problems cause banks to impose
higher interests on their borrowers. A CBS would keep ﬁnance seekers
honest since many of the information they would need to produce
when applying for a loan would be available at the central bank.
4. Conclusion
This paper is a discussion on the relationship between institutions and
ﬁnancial intermediation. There is a preponderance of evidence that poor
institutions inhibit the growth of the ﬁnancial sector, ﬁnancial innova-
tion and contribute to higher costs of credit. There is also evidence
that contracting rights institutions are relevant to facilitating access to
ﬁnance, but are of limited capability to ensure ﬁnancial innovation,
which would allow ﬁrms to issue claims to savers in terms of bonds,
commercial papers, shares, and derivatives. Disintermediated ﬁnancial
environments appear to be consistent with strong state rights at the
expense of private property rights.
It also appears that private citizens develop mechanisms to get
around weak institutions when dealing with each other. They develop
enforcement mechanisms that are rooted in their culture and social
norms for ﬁnancial contracting. Nonetheless, this does not reduce the
costs of funds and may lead to extraction. In fact, it appears that even
formal banking systems engage in extractive lending by charging high
risk premiums often justiﬁed by the level of risk channeled through
the institutions. There is evidence that with better institutions, net
interest margins and interest rate spreads are lower.
Information asymmetric problems are stronger in countries with
poor institutions. Thus, countries where credit information institutions
are embryonic or at best weak, interbank information exchanges can be
increased to remove inefﬁciencies in the banking system. If such a rec-
ommendation is against statutory laws, these deﬁciencies in the laws
need to be addressed so that transaction costs are reduced and adverse
selection problems mitigated.
In countries with weak institutions, embryonic and/or inexistent stock
markets, where corporate governance practices are poor and ﬁnancial
disclosures substandard, ﬁnancing large scale projects might require
loan syndication which will alleviate the incidence of information asym-
metry, boost information sharing, avoid retail banking, remove inefﬁcien-
cies, duplications, and lower transaction costs. Such a strategy would
signiﬁcantly decrease costs of ﬁnancing and increase the availability of
credit while participating banks will diversify their risk exposures.
In countries where private credit information bureaus are nonexis-
tent, public registries should be compulsory, run and operated as central
bank agencies — at least in the early stages. Where such institutions
exist, policymakers should enact laws guaranteeing the conﬁdentiality
of gathered information and criminalize their improper use. The bank
secrecy laws have to be revamped so that they align with the new
idea of using information as a public good and do not interfere with
the good functioning of lawful registries. Effective credit registries
would reduce information asymmetric problems and provide market-
enhancing tools to cope with problems of incomplete ﬁnancial markets,
especially when banks are dealing with informationally challenged
ﬁrms and other ﬁrst-time borrowers.
In terms of policy agenda, we recommend that developing countries
establish a central of balance sheets to which ﬁrms would elect to opt in
voluntarily but with the added possibility of lower interest costs within
the ﬁnancial system as an incentive for participation. Information
extracted from participating ﬁrms' balance sheets may serve as a new
tool for monetary policies and the redeployment of credit across sectors.
Participating ﬁrms would receive a solvency score, which lenders could
use to make their lending decisions. This would keep ﬁnance seekers
honest about their ﬁnancial strengths. This could prove to be very im-
portant, especially in bank based ﬁnancial systems, where ﬁrms' real
ﬁnancial information is hardly known even when they are seeking cred-
it. It could also help to reduce ﬁscal fraud by participating ﬁrms.
References
Acemoglu, D., & Johnson, S. (2005). Unbundling institutions. Journal of Political Economy,
113(5), 949–995.
Acemoglu, D., Johnson, S., & Robinson, A. J. (2001). The colonial origins of comparative
development: An empirical investigation. The American Economic Review, 91(5), 32.
Nigeria
Pakistan
Zimbabwe
Liberia
Zambia
Tanzania
Uganda
Sierra LeoneSwaziland
Ghana
Namibia
St. Lucia
KenyaBotswanaJamaica
South Africa
Lesotho
Dominica
Nepal
Sri Lanka
Micronesia
Belize
Vanuatu
Grenada
St. Kitts and Nevis
Vietnam
Botswana
Guyana
Tonga
Bhutan
Malaysia
Thailand Uzbekistan
Lao
Azerbaijan
Kyrgyz Republic
Cambodia
Russia
Ukraine
Lao
Kazakhstan
Tajikistan
Moldova
Bulgaria
Georgia
AlbaniaSlovak Republic
Hungary
Bulgaria
Armenia
Czech Republic
Latvia
Belarus
Poland
Estonia
Mongolia
LithuaniaMacedonia
Bosnia
CroatiaSlovenia
Afghanistan
Iraq
Angola
Congo
Yemen
Gabon
Angola
Congo
Mexico
Egypt
Congo
Mozambique
Ethiopia
Gambia
Egypt
Indonesia
Chad
Madagascar
Togo
VenezuelaJordan
Central African Republic
Cameroon
Algeria
HondurasMexico
Philippines
Morocco
Guatemala
Burundi
Venezuela
SyriaRwanda
Fiji
Argentina
Nicaragua
Cape Verde
Nicaragua
Suriname
Uruguay
Rwanda
Paraguay
Ethiopia
Honduras
Mauritius
Uruguay
Guatemala
Bolivia
Argentina
BoliviaColombia
Turkey
Costa Rica
Dominican Republic
Colombia
Paraguay
Brazil
Peru
Chile
Peru
Chile
Afghanistan
Iraq
NigeriaAngola
Congo
Yemen
Pakistan
Gabon
Angola
Uzbekistan
Congo
Mexico
Egypt
Zimbabwe
Congo
Liberia
Mozambique
Ethiopia
Zambia
TanzaniaGambia
Uganda
Sierra Leone
Egypt
Indonesia
Lao
Azerbaijan
Kyrgyz Republic
Chad
Madagascar
Cambodia
Russia
Togo
Venezuela
Swaziland
Ghana
Namibia
St. Lucia
Kenya
Jordan
Central African Republic
BotswanaJamaica
South Africa
Cameroon
Algeria
Honduras
Ukraine
MexicoLesotho
Lao
Dominica
Kazakhstan
Philippines
Morocco
Tajikistan
Guatemala
Burundi
Venezuela
SyriaRwanda
FijiNepal
ArgentinaMoldova
Bulgaria
Sri Lanka
Nicaragua
Cape VerdeGeorgia
AlbaniaSlovak Republic
Hungary
MicronesiaNicaragua
Belize
Bulgaria
Armenia
Suriname
Uruguay
Rwanda
Vanuatu
Ethiopia
Paraguay
Czech Republic
Honduras
Mauritius
Latvia
Uruguay
Grenada
Guatemala
Bolivia
St. Kitts and Nevis
Argentina
Belarus
Vietnam
Botswana
BoliviaPoland
Guyana
Estonia
Colombia
Mongolia
Lithuania
Tonga
Costa Rica
Turkey
Dominican Republic
Colombia
Bhutan
Paraguay
Malaysia
Macedonia
Bosnia
Brazil
Peru
Croatia
Chile
PeruSlovenia
Thailand
Chile
020406080020406080
0 20 40 60 80 0 20 40 60 80
English Socialist
French World
Percent of firms with a bank loan/line of credit
Percentoffirmsidentifyingaccesstofinanceasamajorconstraint
Firms' contraints to finance and bank credit per legal system
Fig. 6. Firms' constraints to ﬁnance and bank credit per legal system.
32 I. Marcelin, I. Mathur / International Review of Financial Analysis 31 (2014) 25–33